Items to Think About as the Year Comes to a Close
By Jerry Kissell and Paul Cain
As the tax year comes to a close for your community bank Subchapter S corporation, there are a number of areas in the tax arena that have special rules for S corporations and require special consideration. The following are examples of a few of those areas:
Shareholder Distributions - As you may recall, an S corporation is allowed to distribute to its shareholders the balance in the accumulated adjustments account (AAA) tax free. If the AAA balance was reduced during the current year due to items other than distributions (for example, a current year taxable loss), there is a safe harbor that allows the S corporation to distribute the AAA balance as of the beginning of the year. If the distributions exceed the AAA balance, there are a couple of possible outcomes.
If you were a C corporation prior to making your S corporation election, the excess distributions are taxed as dividends to the extent of C corporation earnings and profits. If the corporation has been an S corporation since its inception, the excess distributions will be a return of capital to the extent of the shareholders' stock basis, and then a capital gain.
If you are planning a year end distribution that may be a taxable dividend due to inadequate AAA, you may want to postpone the distribution until 2011 in the hope that 2011 taxable income will be sufficient to absorb the distribution. However, with the potential for increased tax rates on dividends in 2011, you may want to make the distribution as planned if there is a possibility the distributions may be taxable in 2011 due to insufficient AAA.
The need to monitor your AAA balance with regard to distributions is essential during this time of fluctuating taxable income. This is especially true when you take into account the recent changes to the tax depreciation laws and the impact they can have by dramatically reducing your current year taxable income. See the other article included in this newsletter.
Also, if you were previously a C corporation and still have accumulated earnings and profits from that time, another alternative is to elect to treat all distributions as coming from those earnings and profits. If you think you may have taxable distributions in the future, you may want to try to eliminate the accumulated earnings and profits during the current period of low tax rates on dividends.
Remember, if you pay a dividend from C corporation earnings and profits a 1099-DIV is required, unlike distributions from S corporation AAA. Please consult your tax adviser to see if a dividend from earnings and profits makes sense for your bank.
Accrued Expenses to Shareholders - Generally, if you are an accrual basis taxpayer for income tax purposes, you are allowed to deduct an expense when it becomes fixed and determinable, rather than when you actually pay out the cash. However, there is a special rule regarding accrued expenses and S corporation shareholders. If an expense is payable to any shareholder (even if that shareholder only owns 1 share of stock), the S corporation cannot deduct the expense until the shareholder is required to take it into income. This generally means that the S corporation does not get to deduct the expense until the cash is actually paid.
It should be noted that the deferral of the deduction for accrued expenses includes expenses accrued not only to the shareholder themselves, but also to the shareholder's spouse, brothers, sisters, ancestors (for example, parents and grandparents) and lineal descendents (for example, children, grandchildren, great grandchildren) Some examples of expenses that this rule would apply to are wages, bonuses, rent and interest.
In summary, in order for the S corporation to get a deduction in the current year for expenses payable to shareholders, the expense must be actually paid prior to the end of the year.
Fringe Benefits - Generally, employees are allowed to exclude from their taxable income a number of fringe benefits that they receive from the corporation. However, there are special rules that apply to S corporation shareholder-employees who are considered to be "2 percent shareholders." A 2 percent shareholder is defined as a shareholder that owns more than 2 percent of the S corporation stock on any day of the corporation's taxable year.
For these 2 percent shareholders, certain fringe benefits must be included in their taxable wages on their W-2. While there exists some uncertainty regarding exactly which benefits this applies to, the following common benefits appear to be included:
- Group term life insurance coverage up to $50,000;
- Amounts received under accident and health plans;
- Employer-paid accident and health insurance premiums;
- Meals and lodging furnished for the convenience of the employer; and
- Qualified transportation fringe benefits.
Also, these same 2 percent shareholders should be excluded from participating in any flexible benefit cafeteria plans.
It should be noted that there is a special rule regarding social security tax on the accident and health insurance premiums paid by the S corporation on behalf of the 2 percent shareholders. The Internal Revenue Service, in Announcement 92-16, determined that any accident and health payments made by the S corporation on behalf of the 2 percent shareholder would not be subject to FICA or Medicare tax as long as the payments were made under a plan to benefit all employees, or a class of employees. However, the premiums and other fringe benefits included in wages are subject to income tax withholding.
On the bright side, the health insurance premiums are considered to be self-employed health insurance. As such, the 2 percent shareholder is generally allowed an above-the-line deduction on their individual income tax return equal to 100 percent of the amount of health insurance premiums that were included in their W-2. Therefore, you should be sure to communicate to them the amount included in their W-2 so that they can take the appropriate deduction on their individual tax returns.
Additionally, there are still a number of fringe benefits that these shareholders can benefit from:
- Pension and profit-sharing plans;
- Employee achievement awards;
- Educational assistance programs;
- Dependent care assistance; and
- No-additional cost services, working condition benefits, and de minimus fringe benefits.
The above topics are certainly not an exhaustive list of items to consider as the year-end approaches, and you should consult your tax advisor to discuss other year-end planning issues. However, hopefully the above items will get you started on your year-end planning.
Jerry Kissell is with the Minneapolis office of McGladrey, and Paul Cain is with the consulting firm's Des Moines, Iowa, office.